A contract provision that permits an owner to withhold payment
from a contractor is not a "penalty" clause.
The courts do not like, and typically do not enforce,
"penalty" clauses. For this reason, liquidated damages
clauses in favour of the construction owner generally have to be
based on a "genuine pre-estimate of damages" in order to
avoid the court striking the liquidated damages clause down.
No Further Payment Provisions
In a recent Ontario case, Ottawa Community Housing Corp. V. Foustanellas, the
contractor argued that a clause providing that (in certain
instances of default) "the obligation of the Owner to make
payments will cease" was a penalty clause, and therefore not
legally enforceable. The contractor was overbilling the owner, and
consequently the owner acted on a clause in the contract that
permitted the owner to "take work out of the hands of the
Contractor." The owner then hired someone else to complete the
work, but the Contractor sued to recover payment for the work it
had performed before the owner took the work out of its hands.
Specifically, the contract permitted the owner, upon default by
the contractor, to "take the whole operation, or any part of
the operation out of the hands of the Contractor." The owner
relied upon that clause and a further clause stating:
"...where any or all of the work has been taken out of the
hands of the Contractor, the Contractor will not be entitled to any
further payment, including payments then due and payable but not
yet paid. The obligation of the Owner to make payments will cease,
and the Contractor will be liable upon demand to pay the Owner an
amount equal to all of the losses and damages incurred by the Owner
for the non-completion of the work."
The court decided this last clause did not erase the debt due to
the contractor (if any). It suspended payments due to the
contractor (if any) until a final accounting could be done, after
the owner had the work completed by others. Since the clause only
suspended payments, and it did not erase the debt, it was not a
penalty clause. It was enforceable.
Debts Owing vs. Payments Due
This is not a surprising outcome or new law. But it is useful
case authority for the interpretation of a fairly common contract
provision. It is also a reminder of the distinction between a debt
owing and a payment due. This is a deceptively simple distinction
that is essential to proper interpretation of construction
contracts and lien legislation. I frequently see misinterpretations
of contract and lien legislation due to misunderstandings on this
point. In the Foustanellas case, it appears that the contractor
went to trial on the misinterpretation that the default provisions
in the contract erased the debt, whereas the proper interpretation
was that the default provisions merely suspended the payment
The court called this "a 'stop payment' provision.
It is designed to halt the owner's contractual obligation to
make any payments to the contractor pending determination of the
owner's losses and damages arising from the contractor's
breach of contract." In Foustanellas, the debt was erased, but
not because of a penalty clause. The debt to the contractor was
erased because the owner's increased cost to complete the work
as a result of the contractor's default exceeded the value
earned by the contractor prior to the default.
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